WHOLESALE BANKING & MARKETS IMPACT OF IFRS Johann Kruger CA (SA), CFA and Gerry Daly IFRS and Financial Risk Management Consultants
AGENDA IFRS accounting for financial instruments: Loan FX forward Interest rate swap Cash Liquid resources: investment in bonds
Questions: Determine which of the following scenarios is a cash flow, fair value or net investment hedge and explain why… Corporate A issues a fixed rate bond and then uses an interest rate swap to convert that to floating rate debt. This is a cash flow hedge True False Depends Corporate B (£ functional ccy) issues a fixed rate $ bond and uses an interest rate swap to convert that to fixed rate £ debt. This is a fair value hedge True False Depends Bank A receives floating deposits from customers and protects against rises in interest rates using interest rate caps. This is a cash flow hedge True False Depends
Questions: Determine which of the following scenarios is a cash flow, fair value or net investment hedge and explain why… Corporate C hedges its floating rate facility by using interest rate swaps to convert floating rate debt to fixed rate debt. This is a cash flow hedge True False Depends Corporate D sells an interest rate Floor to generate income. It has floating rate debt which it wishes to hedge. This is a cash flow hedge True False Depends Corporate E issues inflation linked debt and uses an interest rate swap to convert to fixed rate debt. This is a cash flow hedge True False Depends
CASE STUDY: MEET ENGINE LTD Winning commercial contracts and managing financial risks
High value-add UK engineering company Engine Ltd UK held company Pays dividends in £ £ and US$ denominated costs £, US$ and EUR denominated sales 30% gross margin 15% net profit margin Holds only minimally necessary cash
Engine wins a large contract In May 2011 Engine ltd signed a contract for sale of engine components to big UK name (a defense contractor) Contract involves sourcing a significant amount of high-tech components from the US Competitors are in US, Brazil and Singapore Where should Engine Ltd base the production for the contract? Hedge FX on USD purchases? How should Engine Ltd fund the project? 6
FUNDING THE PROJECT, INTEREST RATE RISK Borrowings, cash, short term investments and hedging the interest rates
Funding the project Engine arranges a bank borrowing of £10m, with a bullet repayment in 4 years Expects interest rates to rise soon – enters into an interest rate swap (‘IRS’) Draws on the loan but does not need the cash for 6 months – invests in high quality corporate bonds Later sells the bonds and spends cash on incremental CAPEX for the project
Financial Instruments Measurement Categories – IAS 39 -How would the borrowing be classified? Fair value -And the cash? revaluation: FINANCIAL LIABILITIES Fair value Fair value PL FINANCIAL ASSETS through PL through PL Not Held to Other revalued maturity liabilities Loans and Not receivables revalued Available for Equity sale
How would a loan (or a deposit) be recorded at inception? And £60 At fair value… Interest Principal Receive £1,000 now Interest (coupon) Loan @ £60 £60 £60 inception Time Year 1 Year 2 Year 3 Year 4 - £1,000 Total future Discounting at 6% cash flows:£1,240
How would the investment in bonds be classified? FINANCIAL LIABILITIES Fair value Fair value FINANCIAL ASSETS through PL through PL Held to Other maturity liabilities Loans and receivables Available for sale
Corporate Bond Investment : Change in Fair Value due to Change in Market Interest Rates And Interest £60 @ end of year 1 Principal Future Interest (coupon) £1,000 Already £60 £60 Value now happened Time Year 1 Year 2 Year 3 Year 4 Was £1,000 - £901 Now £901, FV loss: Discounting Total future £99 cash flows: at 10% £1,180
Available for Sale: ongoing Equity Profit or loss £99 Fair value Revaluation loss £60 Interest
Available for Sale: on sale of the investment Equity Profit or loss £99 Fair value Revaluation loss
Funding the project – interest rate risk Borrowed £10m, bullet 4 years Expects interest rates to rise– enters into an interest rate swap
Interest rate exposure Balance sheet + £10m - 10m Operating assets Floating rate debt Cash Flow & Accounting Profit & Loss account Volatility + Fixed revenue - Floating interest (uncorrelated with i%) Revenue uncorrelated to interest vs. floating interest on debt
Interest rate hedge – before IFRS (UK GAAP) Balance sheet - Fixed i% + floating i% SWAP + £10m -£10m (FV) Operating assets Floating debt = Smoother Profit & Loss account cash flows + floating interest (swap) - floating interest (debt) + Fixed revenue and - Fixed i% (swap) (uncorrelated with i%) accounting profits UK GAAP: swap is off BS, coupon accruals in P&L acct
Interest rate swap cash flow hedge - IFRS Balance sheet £1.5m fair value - Pay Fixed + floating SWAP = - £10m + £10m Housing assets Floating rate debt Smoother Cash Profit & Loss account flows - Floating interest + Fixed revenue Acct (uncorrelated with i%) Volatility – Float Dr £1.5m change in FV - Pay Fixed interest and + floating SWAP swap FV Assume swap fair value is £1.5m liability Assuming hedge accounting not applied Cash flow position is hedged However P&L for the year will be volatile due to swap fair value movement
Cash flow hedge accounting Balance sheet Liabilities Assets £1.5m fair value - Pay Fixed + floating SWAP + £10m - £10m Operating assets Floating rate debt Equity Release to P&L Profit & Loss account Dr £1.5m change in FV - Fixed - Floating + Fixed revenue - Fixed interest - Pay Fixed interest interest + floating SWAP Charge (per the swap) (uncorrelated with i%) CFH accounting allows to “park” fair value of the swap in equity And then release a portion to P&L to reflect the hedged rate
Hedge effectiveness test for IRS – an example
Key Phases Of A Swap Underwrite And Syndication PRE EXECUTION AT EXECUTION SYNDICATION PHASE Transparent: Confidential: Relationship: Competitive: “Market Hedge” Counterparties Market hedge Banks supply Smart Hedge informed and & relationship transacted credit / reviews pricing banks for intermediation based on intermediation levels & selects syndication effected agreed margin level counterparties agreed 1 2 3 4 5
The hedging/hedge accounting process 1. Defining the hedge structure 2. Testing it against IAS 39 criteria Reliable 3. Exploring the impact of not applying hedge accounting measurement of 4. Design desired solution effectiveness 5. Producing hedge documentation 6. Prospective hedge effectiveness testing FORMAL DESIGNATION 7. Retrospective hedge effectiveness testing formal hedge The hedge is documentation + 8. Accounting journal entries expected to be risk management policy and is highly effective
IAS 39 requires hedge effectiveness between 80-125%: Requires hedge effectiveness between 80 ‐ 125%: No hedge accounting (P&L) 125% Ineffectiveness to P&L Hedge 100% Effectiveness CF: No Ineffectiveness 80% FV: Ineffectiveness to P&L No hedge accounting (P&L) Regression parameters R-squared >.8 Slope 0.8 to 1.25 IAS 39.96 Cash flow hedge lesser of the cumulative change
IAS 39 – Overview of the CFH and other models Hedge How is P&L fair value volatility neutralised Timing of income statement recognition of deferred Type derivative gains/losses Cash Remove volatility from Income statement – post When underlying cash flow occurs Flow it to equity Hedge Remove volatility from Income statement – post it to Upon disposal of underlying net investment Net Invest. equity Hedge Fair Show fair value of underlying item in balance sheet N/A and post changes to income statement to offset Value Hedge those of the derivative Note : CFH and NIH still impact ratios involving equity and the reserves available for dividend payments Objective is to remove volatility from the income statement
HEDGING THE FX RISKS OF THE PROJECT Protecting the downside FX value of future cash flows
Hedging FX Engine decides to use FX options to hedge FX risk of USD purchases Matching maturity and amount and currency Designated as cash flow hedges Intrinsic value basis Delivery of components to Energy Ltd is delayed, the USD cash flows occur 2 months late Energy would need to amend the hypothtical derivatives, keep hedge relationship, little impact on effectiveness Options rolled into forwards Forwards settled net
Hedge designation: FX options Time Value Future US$ cash flow -10 US$ Intrinsic Jan 2012 May 2011 Value Option to buy +10 US$ buy £ Jan 2012 May 2011
Hedge Effectiveness Report for an FX Option
FX Option – Hedge Accounting Journals
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